Policy Responses to Balance-of-Payments Crises: The Role of Elections

J. Lawrence Broz,Jeffry A. Frieden,Maya J. Duru

doi:10.1007/s11079-016-9387-y

J. Lawrence Broz, Jeffry A. Frieden + Show 1 more

Open Access

https://doi.org/10.1007/s11079-016-9387-y

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Abstract

Governments have a number of policy tools that can be used to address pressure on the balance of payments, threatening an undesirable decline in the relative value of the national currency. They can: (1) sell reserves, (2) raise interest rates, (3) impose capital controls, (4) apply trade restrictions, or (5) depreciate the currency. While researchers typically analyze these policies in isolation from one another, we treat them as a menu of options available to election-minded politicians. We analyze the use of these five policy responses to payments difficulties for a large sample of countries since the early 1970s. We argue that governments try to minimize political costs by adopting less transparent policies first and only moving to more visible policies as necessary, delaying the most visible and politically costly policies until after elections. The evidence is consistent with these claims: governments are more likely to draw down reserves and impose capital controls before other options. If these policies do not succeed, they tend to raise interest rates. If further action is needed, they delay devaluations and trade protection until after elections.

Highlights

Governments have a rich toolbox of policies at their disposal to manage exchange rates and attempt to avoid currency crises
Political Economy Determinants of Policy Choice we focus on the correlation between election timing and politicians’
If we find that a previous policy positively predicts an equivalent or more politically costly subsequent policy, we interpret this as evidence for our hypothesis that when policymakers face continuous pressure that is not relieved by a single policy they will tend to choose among relatively less politically costly policies first and only move on to costlier options if pressure persists

Summary

Introduction

Governments have a rich toolbox of policies at their disposal to manage exchange rates and attempt to avoid currency crises. When faced with pressure on the balance of payments – whether due to a slowdown or sudden stop of capital inflows, a terms of trade shock, or some other factor -- policymakers can: (1) sell reserves to support the currency, (2) raise interest rates to encourage capital inflows, (3) impose capital controls to limit sales of domestic assets, (4) apply a combination of import tariffs and export subsidies to stimulate demand for domestic products, or (5) depreciate the currency.1 Since these policy tools may substitute for or complement one another, the challenge for researchers is to explain why governments adopt one policy over another--or a combination of policies--when faced with exchange market pressures. While Forbes and Klein (2015) concentrate on four crisis policy responses (i.e., reserve sales, currency depreciations, interest rate increases, and capital controls), we add trade policy as a fifth potential response to crises.

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